Friday, 30 August 2013

Despite appearances to the contrary, I do not think Krugman and DeLong actually disagree with me on the
dominance or otherwise of the New Keynesian business cycle model in academia. I
wrote:

“Yet in many who were part of the New Classical revolution, or
who were taught by its leaders, there remains a deep antagonism to Keynesian
ideas…. As a result, in certain places NK theory was tolerated rather than
embraced, or was quietly marginalised.”

That was a key point of the post, although I admit I did take
rather a long time getting there.

So I do not think there is any qualitative disagreement. The
New Keynesian model is the dominant model of business cycles in central banks.
In academia it is not dominant. Is it still the framework of first choice for
the majority, as I suspect, or only about half of academics, as DeLong
suggests? Impressions gained from non-random contacts or gatherings are not
good evidence, so I was relying more on this survey, but that is just one particular
sample. And it would be interesting to know results for other countries besides
the US - particularly those that have chosen to embrace austerity or advocate
it for others.

I did find some evidence from a survey of grad students undertaken by David
Colander in 2005. This only covered the major US schools, but from Table 5 you
will find that 22% of students from Chicago believed price rigidities were
unimportant, while the equivalent number for Harvard was zero. 13% of Chicago
students and 20% from Stanford disagreed that ‘fiscal policy can be an
effective stabilizer’ (Table 6). But perhaps more revealing are some of the observations
Colander makes in the text. Here is one.

“The students told me that the differences in policy views on
macro that showed up in the survey did not reﬂect what they were taught about
policy in macro, since they were taught almost nothing about macro policy, but
reﬂected their undergraduate training. When asked about survey results showing
that students at his school had changed their views on policy, one student
stated, “I think that in the macro course we never talked about monetary or
ﬁscal policy, although it might have been slipped in as a variable in one
particular model, but that wasn’t the focus, so it didn’t come from the courses.”
Another stated, “Monetary and ﬁscal policy are not abstract enough to be a
question that would be answered in a macro course.”

I guess it might be possible to teach the NK model as if you
were not talking about policy, but it would be an odd thing to do.

For me this reaffirms Paul Krugman comment that, “It would be
interesting to know how many graduate departments were in fact teaching New
Keynesian macro in 2008”. Even if records on this are not immediately
available, memories should still be reasonably fresh. And knowing what is
taught in 2013 should at least give us a lower bound. A good indicator of
academics’ views is what they teach or what they were taught. I don’t think
this information has been collected by anyone, and I think it would be a
valuable thing to do if anyone has the time. [1] What I am pretty sure about is
that, in twenty years time, some people will write about this, and it would be
nice for them to have some more concrete evidence: the time to collect it is
now.

[1] I think the key number here should be the proportion of a
core masters macro course that is devoted to New Keynesian analysis (i.e. any
DSGE model with sticky prices, and policy analysis using that model). Obviously
zero would be a very interesting finding, but one week out of twenty is also
somewhat suggestive. Measurement is tricky of course, but my quick estimate of
this number for the current Oxford MPhil, which would also apply to 2008, is
around 20-30%.

Information on current teaching should either be available from
the web, or available on request from the departments. However it would be
interesting to try and collect information from recent students as a cross
check. As one academic once told me: “I intended to cover NK economics but I
just ran out of time”.

Wednesday, 28 August 2013

A long post I’m afraid,
even with extensive use of footnotes. But I really think it is much more
productive to try and understand someone’s opposing point of view than just be
rude about it.

Most academic macroeconomists are just trying to advance the
discipline by getting their papers published, and are certainly not consciously
trying to defend some ideological viewpoint. As a result, there are lots of
macroeconomists producing high quality work in a wide variety of diverse areas.
There are many interesting new ideas being explored. Furthermore this work can
be appreciated by most fellow researchers. Unlike the 60s and 70s, where
members of different schools of thought talked across each other, we now have a
shared language as a result of the microfoundation of macro. My own view is
that as a result macro today is much more interesting than macro was back then.
Furthermore, this work can be useful to policymakers, as Paul Krugman
outlines in the case of monetary policy here.

Ahh - that may have made you pause for thought. Isn’t that the
same Paul Krugman who says there is something “deeply wrong with
economics”.Who talks about how ideology and politics distort the advice
that economists - and perhaps particularly macroeconomists - give to policymakers.
And who suggests that in many cases policymakers would be better off thinking
about good old IS-LM than any of this more modern stuff.

One of the problems when Paul Krugman does this is that it gets
on the nerves of many academic macroeconomists, who would much rather identify
with the sentiments I express in my first paragraph. Economists like Tony
Yates, for example. I suspect they see Paul Krugman’s
attacks on the state of macroeconomics as akin to a personal attack on their own
and colleagues work, and as a result they can go way over the top in reaction.
I think this is understandable, but it is wrong.

As I see it both points of view are correct. As Stephen
Williamson argues, in one sense macroeconomics is
flourishing. Take the example of financial frictions. There is now a wealth of
papers out there exploring different types of friction, in large part
responding to events of just the last five years. This is hardly the response
of a moribund, out of touch discipline. And as Krugman says, sometimes this
work can be useful to policymakers. But that is not the acid test for the
integrity of a supposedly scientific discipline. In days of old, policymakers
made much use of astrology. The acid test is when the discipline tells
policymakers something they do not want to hear, and unites behind this implication
of its models and the data.

Nearly fifteen years ago I began working with DSGE models
looking at monetary and fiscal interactions. [1] Doing this work taught me a
lot about how fiscal policy worked in New Keynesian models. I understood more clearly why monetary policy
was the stabilisation tool of choice in those models, but also why fiscal
policy - appropriately designed - was also quite effective in that role if
monetary policy was absent (individual countries in the Eurozone) or impaired
(the ZLB). Why New Keynesian models? Because if you were interested in business
cycle stabilisation, that is the framework that most involved in that area
(academics and policymakers) were using. So when we hit the ZLB, the reaction
of policymakers in using fiscal stimulus seemed logical, entirely appropriate
and fully in line with current theory.

I also found that in these models the basics of
Barro’s tax smoothing hypothesis continues to apply, so if you needed to reduce
debt, you should do so as gradually as possible. This also seemed like as
robust a result as one can get in macro.

The acid test for macro came in 2010. Policymakers, for a
variety of reasons, went into reverse with fiscal policy. Austerity replaced
stimulus around the world. If academic macroeconomists had been true to their
discipline, they would have been united in saying that our standard models tell
us this will reduce output and raise unemployment. They would have said that if
markets allow, the time to reduce debt is when the ZLB comes to an end, and
then it should be done gradually. Many did say that, but many did not. This
division at least encouraged policymakers to continue with austerity.

So macroeconomists as a collective failed this test, repeating
errors made in the 1930s. But unlike the 1930s, it did not have ignorance as an
excuse.

This is a crucial point that many on both sides tend to ignore.
In 2010, the standard business cycle model was the New Keynesian model, and the
implications of that model for the efficacy of appropriately designed fiscal
policy are clear. So to blame the failure of 2010 on the current dominant macro
model is just wrong. You may not like that model, but it cannot be blamed for
the widespread adoption of austerity, or the ambivalent attitude of many
macroeconomists towards that policy change.

So in my view macroeconomists, not the dominant macroeconomic model,
failed. Why? The easy answer is to say that macroeconomists were too influenced
by ideology, but I think for most (not all) it is the wrong answer, as I said
in my opening paragraph. I think for most (not all) it is not simple politics, so in that respect I agree with Stephen Williamson. [2] So what is it?

Here is one possible answer. First I have to appeal to
macroeconomists who learnt their trade after the New Classical revolution to
consider where the now dominant methodology in macro came from. If you start
your history of macro thought in 1980, then everything can seem nicely
progressive. First there were RBC models, applying basic micro to macro. The
data showed that this framework could not explain how monetary policy appeared
to work, so to resolve this puzzle New Keynesian theory was developed.

But it was not like that at all. [3]

Macro started well before 1980. Its theoretical basis may have
been shaky, but it was a scientific discipline in the Popperian sense. The New
Classical revolution attempted to kill off Keynesian ideas, and deny the
importance of aggregate demand. In that respect it now seems clear, because of
the dominance of New Keynesian theory, that this was regressive rather than
progressive.

Yet in many who were part of the New Classical revolution, or
who were taught by its leaders, there remains a deep antagonism to Keynesian
ideas. This was not enough to prevent the emergence of New Keynesian theory,
but the NK model built upon rather than challenged the RBC framework, and it
could always be dismissed with an assertion about price flexibility. As a
result, in certain places NK theory was tolerated rather than embraced, or was
quietly marginalised.

This attitude was facilitated by another aspect of the
revolution. Although it failed to kill Keynesian economics, it did succeed in
changing how macro was done. Microfoundations macro did not just become an
important way of explaining the economy, it became the only acceptable way. Now
we can debate the wisdom of that. But I think it is
very difficult to deny that this methodological revolution reduced the
discipline that data can provide on model proliferation. It becomes far too easy to say ‘but in this model something
different happens’, even if there is compelling empirical evidence that said
model is not applicable. [4] [5]

I think this may help explain why a good proportion of
macroeconomists failed to advocate fiscal stimulus in 2009 and call the
consequences of subsequent austerity. [6] Now you may disagree with my view
that this represented a failure for macroeconomists as a whole. What I want to
convince you of here is that my view that it did, and perhaps similar views of
others, does not amount to an assertion that modern macro is fundamentally
flawed, and that those working within it are wasting their time. While the New
Classical revolution may have moved macro many steps forward, in condemning
Keynesian ideas it took one large step backwards, and the consequences of that
mistake are still with us.

[1] In part this was a reaction to a different policy decision.
The work of various economists before the formation of the Euro had suggested
that countercyclical fiscal policy should be a key stabilisation tool for
individual Eurozone members. That work was ignored by policymakers, and they
were backed up by a significant number of macroeconomists, in part using other
models that focused on free rider problems and fiscal dominance. How this all
turned out is another story, but once again the collective of
academic macroeconomists hardly covered itself in glory.

[2] Personally, I do not think the actions of some eminent
economists who ignore their economics when batting for their favoured
politicians is critical here, regrettable though it is. Nor on its own were
the comments of other eminent macroeconomists who appeared not to have kept up
with the literature, although as I suggest here I think this was indicative. Both could
have been isolated examples, quickly brushed aside. More revealing is this survey, where although 46% of economists
agreed that the US stimulus was a good policy, a large 40% were uncertain or
did not answer. That is just one survey, but it reflects a similar division
amongst the macroeconomists I know, and the views you find on the web. See, for
example, the quote from Tom Sargent in Stephen Williamson’s
post. Now I think some of this 40% are equivocal about fiscal stimulus (and therefore
not too worried about austerity) because of a deep distrust of government
intervention or the state. Whatever the merits of this mistrust, this is
exactly the ideology and politics that Paul Krugman and I complain about. I
think some others of this 40% take a view that monetary policy is still up to
the job, even at the ZLB. I have talked about this most recently here. This post provides a third possible
explanation, although I am sure there are others. (I tried to be comprehensive here.)

[3] Getting the history of macro thought right is important for
other reasons as well. As I suggested here, the structure of NK models may owe as
much to the need to work with rather than against the then dominant RBC
paradigm, as to any intrinsic empirical merits of that structure.

[4] I have tried to argue that economists working in central banks
take more notice of the data, which helps explain why the NK model is dominant
there, but Stephen Williamson disagrees.

[5] Another arguable consequence is that modelbuilding became
too conformist. The charge that some element of a model is ad hoc and lacks
microfoundations hangs like a Sword of Damocles over modelbuilders. Probably
too much intolerance of alternative methodologies came with this revolution as
well. I think this is part of any explanation of why so little work was done on
financial frictions before 2008, as Mark Thoma suggests.
Again I am not arguing that the methodology is wrong, but instead that it may
have certain perhaps unintended and unfortunate consequences. In my own
experience if you talk to many microeconomists about DSGE in macro they can be
quite critical: for example about how narrow the micro used is, or how obsessed
with technicalities the analysis can become. Sometimes they can be downright dismissive.

[6] You could argue that ideology lay behind the New Classical
revolution’s attempt to kill off Keynesian economics, and I do not really know
enough to agree or disagree. What I do think is that most of those involved in
the revolution thought that they were just exposing deficient theory, which in
many cases they were.

Monday, 26 August 2013

Economics rightly comes in for a lot of stick for failing to
appreciate the possibility of a financial crash before 2007/8. However it is
important to ask whether things would have been very different if it had. What
has happened to financial regulation after the crash is a clear indication that
it would have made very little difference.

There is one simple and straightforward measure that would go a
long way to avoiding another global financial crisis, and that is to substantially increase the proportion of
bank equity that banks are obliged to hold. This point is put forcibly, and in
plain language, in a recent book by Admati and Hellwig: The Bankers New
Clothes. (Here is a short NYT piece by Admati.) Admati
and Hellwig suggest the proportion of the balance sheet that is backed by
equity should be something like 25%, and other estimates for the optimal amount of bank
equity come up with similar numbers. The numbers that regulators are intending
to impose post-crisis are tiny in comparison.

It is worth quoting the first paragraph of a FT review by Martin Wolf of their book:

“The UK’s Independent Commission on Banking, of which I was a
member, made a modest proposal: the proportion of the balance sheet of UK
retail banks that has to be funded by equity, instead of debt, should be raised
to 4 per cent. This would be just a percentage point above the figure suggested
by the Basel Committee on Banking Supervision. The government rejected this,
because of lobbying by the banks.”

Why are banks so reluctant to raise more equity capital? One
reason is tax breaks that make finance using borrowing cheaper. But non-financial
companies, that also have a choice between raising equity and borrowing to
finance investment, typically use much more equity capital and less borrowing.
If things go wrong, you can reduce dividends, but you still have to pay
interest, so companies limit the amount of borrowing they do to reduce the risk
of bankruptcy. But large banks are famously too big to fail. So someone else
takes care of the bankruptcy risk - you and me. We effectively guarantee the
borrowing that banks do. (If this is not clear, read chapter 9 of the book here. The
authors make a nice analogy with a rich aunt who offers to always guarantee
your mortgage.)

The state guarantee is a huge, and ongoing, public subsidy to the banking sector. For large
banks, it is of the same order of magnitude as the profits they make. We know
where a large proportion of the profits go - into bonuses for those who work in
those banks. The larger is the amount of equity capital that banks are forced
to hold, the more the holders of that equity bear the cost of bank failure, and
the less is the public subsidy. Seen in this way it becomes obvious why banks
do not want to hold more equity capital - they rather like being subsidised by
the state, so that the state can contribute to their bonuses. (Existing equity holders
will also resist increasing equity capital, for reasons Carola Binder summarises based on the work of Admati and
Hellwig and coauthors.)

This is why the argument is largely a no brainer for economists. [1] Most economists are
instinctively against state subsidies, unless there are obvious externalities
which they are countering. With banks the subsidy is not just an unwarranted
transfer of resources, but it is also distorting the incentives for bankers to
take risk, as we found out in 2007/8. Bankers make money when the risk pays
off, and get bailed out by governments when it does not.

So why are economists being ignored by politicians? It is
hardly because banks are popular with the public. The scale of the banking
sector’s misdemeanours is incredible, as John Lanchester sets out here. I suspect many will think that banks are
being treated lightly because politicians are concerned about choking off the
recovery. Yet the argument that banks often make - holding equity capital
represents money that is ‘tied up’ and so cannot be lent to firms and consumers
- is simply nonsense. A more respectable argument is that
holding much more equity capital would translate into greater costs for bank
borrowers, but David Miles suggests the size of this effect would not be
large. (See also Simon Johnson here, John Plender here and Thomas Hoenig here.) In any case, public subsidies are bound
to be passed on to some extent, but that does not justify them. Politicians are
busy trying to phase out public subsidies elsewhere, so why are banks so
different?

There is one simple explanation. The power of the banking lobby (and the financial industry more generally) is immense, from campaign
contributions to regulatory capture of various kinds. It would be nice to imagine that the UK
was less vulnerable than the US in this respect, but
there are good reasons to think otherwise. [2] As a result, the power and
influence of banks and bankers within government has hardly suffered as a
result of the Great Recession that they played a large part in creating.

So to return to my original question, would it really have made
much difference if more mainstream economists had been fretting about the position
of the financial sector before the crisis? I think they would have been ignored
then even more than they are being ignored now. The single most effective way
of avoiding another financial crisis is to reduce the political influence of
the banking sector.

[1] The optimum amount of equity is not 100%, in part because
some (subsidised) borrowing does increase discipline on bankers. For a good
discussion of other measures that might reduce the too big to fail problem, see this speech from Andy Haldane. An alternative
to the state picking up the bill is to inflict losses on depositors, but the
economic problems with this are pretty obvious. Nicolas Véron discusses the difficulties the Eurozone has
got itself into with this following the Cyprus crash: see also Simon Johnson here.

[2] In Europe, we had what Mark Blyth describes as the biggest bait-and-switch
operation in modern history, where a banking crisis involving private sector
debts was turned into a public sector debt crisis. While I would be the last
person to defend
the macroeconomics status quo, I also think there is an element
of bait and switch in the ‘macroeconomics in crisis’ idea. Macroeconomic theory
tells us a lot of useful
things about how to get out of the recession, if only politicians would
take some notice.

Saturday, 24 August 2013

The IMF have just published a working paper entitled: ‘Assessing the Impact and
Phasing of Multi-year

Fiscal Adjustment: A General Framework’. Or to put it more simply: should austerity be front loaded or delayed? A really important topic
and one where the views of the IMF are of some importance.

I guess if you call anything a ‘General Framework’ you are
taking a risk. But honestly, if you also write this

“our framework does not explicitly model the monetary policy
response, which could have an important impact on output”

then you have no business using the word ‘Framework’, let alone
‘General’. [1]

We need to go through the logic one more time. When
monetary policy is not constrained (we are not at the Zero Lower Bound),
monetary policy can (and to a first approximation should) completely offset the
impact of any fiscal consolidation. The
multiplier in that case will be approximately zero. [2] However if we are at the
ZLB, then within the current monetary policy framework (essentially inflation
targeting), and unless you are really optimistic about unconventional policy,
the ability of monetary policy to stimulate aggregate demand is severely
compromised. As a result, any fiscal multiplier will be substantially greater
than zero.

Now consider two periods. In the first, we are at the ZLB. In
the following period, we are not. Consider two fiscal consolidation programmes.
In the first, everything is front loaded into the first period. In the second,
nothing happens in the first period, and all fiscal consolidation takes place
in the second. Design the two programmes so that we end up with the same debt
to GDP ratio by the end of the second period, so they are neutral in this
respect.

What is the overall impact on output of the two programmes?
Frontloading hits output in the ZLB period, with possible hysteresis effects in
the second. Delaying consolidation until the second period has no impact on output whatsoever, because
any impact on output is offset by monetary policy. Simple. So the choice is a
no-brainer - you delay fiscal adjustment until the ZLB period has ended.

You would think that with these very dramatic implications for
the optimal path for fiscal consolidation, allowing for monetary policy would have to be part of any ‘general
framework’. Not the whole of any such framework, of course. You would want to
consider the particular situation of countries without their own monetary
policy. You would also want to consider countries where credibility was so low
that delay would raise interest rates on debt (which the paper does do). And of
course many countries are not at the ZLB. However some rather large ones are (like
the US or the Eurozone as a whole), so ignoring monetary policy in any ‘general
framework’ is just crazy.

What the paper does do is allow the size of the multiplier to
vary with the output gap. Now you might think that this does something similar
to allowing for a monetary policy response and the ZLB. However the way the paper sets things up it does not, because it fails to allow
for the fact that outside the ZLB, monetary policy can offset the impact of
fiscal policy. In their simulations the gradual (not front loaded)
consolidation paths still involve large output losses, because they assume that
without fiscal adjustmentthe output gap would be zero, so delaying fiscal adjustmentcreates a large negative output gap,
which leads to a large multiplier. So this completely misses the idea that
monetary policy could and should offset the impact of fiscal consolidation once
we are well clear of the ZLB.

This is by now such an obvious and basic point I can only
wonder why it is not incorporated into the analysis. By ignoring this point,
what has been done is just inapplicable to some major economies. I do not like being so critical and blunt, but this is no academic debating point. And I would hate
to think that this reasoning has been ignored precisely because its implications
about the timing of fiscal consolidation are so clear.

[1] The paper says, immediately after the quote I give in the main text: "This is reflected implicitly in the fiscal multiplier assumptions in our framework (which can be allowed to vary with the output gap), but future work would be needed to explicitly integrate the monetary policy response into the picture." I discuss below why the 'reflected implicitly' is misleading, and also how the impact of monetary policy could have been captured quite simply.

[2] Approximately, because policy may be targeting inflation instead of or as well as output, and the inflation/output implications of monetary and fiscal policy may differ. It would be wrong in this case to say that multipliers would still be positive because monetary policy is not perfect (and to use something like a Taylor rule to reflect that). Here we are looking at planned fiscal consolidations, which the monetary authorities will know about well in advance. Of course uncertainty means that monetary policy makers will not exactly offset the impact of expected shocks, but they may over compensate (negative multiplier) as well as under compensate (positive multiplier).

Friday, 23 August 2013

Do all those using New Keynesian models have to believe everything in those models? To answer this question, you have to know the
history of macroeconomic thought. I think the answer is also relevant to
another frequently asked question, which is what the difference is between a
‘New Keynesian’ and an ‘Old Keynesian’?

You cannot understand macro today without going back to the New
Classical revolution of the 1970s/80s. I often say that the war between
traditional macro (Keynesian or Monetarist) and New Classical macro was won and
lost on the battlefield of rational expectations. This was not just because
rational expectations was such an innovative and refreshing idea, but also
because the main weapon in the traditionalists armoury was so vulnerable to it.
Take Friedman’s version of the Phillips curve, and replace adaptive
expectations by rational expectations, and the traditional mainstream Keynesian
story just fell apart. It really was no contest. (See Roger Farmer here,
for example.)

I believe that revolution, and the microfoundations programme
that lay behind it, brought huge improvements to macro. But it also led to a
near death experience for Keynesian economics. I think it is fairly clear that
this was one of the objectives of the revolution, and the winners of wars get
to rewrite the rules. So getting Keynesian ideas back into macro was a slow
process of attrition. The New Classical view was not overthrown but amended.
New Keynesian models were RBC models plus sticky prices (and occasionally
sticky wages), where stickiness was now microfounded (sort of). Yet from the New Classical point of
view, New Keynesian analysis was not a fundamental threat to the revolution. It
built upon their analysis, and could be easily dismissed with an assertion
about price flexibility. Specifically NK models retained the labour leisure choice, which was at the heart of RBC analysis. Monetary policymakers were doing the Keynesian thing
anyway, so little was being conceded in terms of policy. [1]

So labour supply choice and labour market clearing became part of the core New Keynesian
model. Is this because all those who use New Keynesian models believe it is a
good approximation to what happens in business cycles? I doubt it very much.
However for many purposes allowing perfect labour markets does not matter too
much. Sticky prices give you a distortion that monetary policy can attempt to
negate by stabilising the business cycle. The position you are trying to
stabilise towards is the outcome of an RBC model (natural levels), but in many
cases that involves the same sort of stabilisation that would be familiar to
more traditional Keynesians.

This is not to suggest that New Keynesians are closet
traditionalists. Speaking for myself, I am much happier using rational expectations than
anything adaptive, and I find it very difficult to think about consumption
decisions without starting with an
intertemporally optimising consumer. I also think Old Keynesians could be very
confused about the relationship between aggregate supply and demand, whereas I find the New Keynesian approach both coherent
and intuitive. However, the idea that labour markets clear in a recession is
another matter. It is so obviously wrong (again, see Roger Farmer). So
why did New Keynesian analysis not quickly abandon the labour market clearing
assumption?

Part of the answer is the standard one: it is a useful
simplifying assumption which does not give us misleading answers for some questions. However the reason for
my initial excursion into macro history is because I think there was, and still
is, another answer. If you want to stay within the mainstream, the less you
raise the hackles of those who won the great macro war, the more chance you have
of getting your paper published.

There are of course a number of standard ways of complicating
the labour market in the baseline New Keynesian model. We can make the labour
market imperfectly competitive, which allows involuntary unemployment to exist.
We can assume wages are sticky, of course. We can add matching. But I would
argue that none of these on its own
gets close to realistically modelling unemployment in business cycles. In a
recession, I doubt very much if unemployment would disappear if the unemployed
spent an infinite amount of time searching. (I have always seen programmes
designed to give job search assistance to the unemployed as trying to reduce
the scaring effects of long term unemployment, rather
than as a way of reducing aggregate unemployment in a recession.) To
capture unemployment in the business cycle, we need rationing, as Pascal
Michaillat argues here (AER article here). This is not an alternative to these other
imperfections: to ‘support’ rationing we need some real wage rigidity, and
Michaillat’s model incorporates matching. [2]

I think a rationing model of this type is what many ‘Old Keynesians’ had
in mind when thinking about unemployment during a business cycle. If this is
true, then in this particular sense I am much more of an Old Keynesian than a
New Keynesian. The interesting question then becomes when this matters. When
does a rationed labour market make a significant difference? I have two
suggestions, one tentative and one less so. I am sure there are others.

The tentative suggestion concerns asymmetries. In the baseline
NK model, booms are just the opposite of downturns - there is no fundamental
asymmetry. Yet traditional measurement of business cycles, with talk of
‘productive potential’ and ‘capacity’, are implicitly based on a rather
different conception of the cycle. A recent paper (Vox) by Antonio Fatás and Ilian Mihov takes a
similar approach. (See also Paul Krugman here.) Now there is in fact an asymmetry
implicit in the NK model: although imperfect competition means that firms may
find it profitable to raise production and keep prices unchanged following
‘small’ increases in demand, at some point additional production is likely to
become unprofitable. There is no equivalent point with falling demand. However
that potential asymmetry is normally ignored. I suspect that a model of unemployment based on rationing will produce asymmetries
which cannot be ignored.

The other area where modelling unemployment matters concerns
welfare. As I have noted before,
Woodford type derivations of social welfare give a low weight to the output gap
relative to inflation. This is because the costs of working a bit less than the
efficient level are small: what we lose in output we almost gain back in additional leisure. If we
have unemployment because of rationing, those costs will rise just because of
convexity. [3]

However I think there is a more subtle reason why models that
treat cyclical unemployment as rationing should be more prevalent. It will
allow New Keynesian economists to say that this is what they would ideally
model, even when for reasons of tractability they can get away with simpler models
where the labour market clears. Once you recognise that periods of rationing in
the labour market are fairly common because economic downturns are common, and
that to be on the wrong end of that rationing is very costly, you can see more
clearly why the labour contract between a worker and a firm itself involves
important asymmetries - asymmetries that firms would be tempted to exploit during a recession.

Yet you have to ask, if I am right that this way of modelling
unemployment is both more realistic and implicit in quite traditional ways of
thinking, why is it so rare in the literature? Are we still in a situation
where departures from the RBC paradigm have to be limited and non-threatening
to the victors of the New Classical revolution?

[1] When, in a liquidity trap, macroeconomists started using
these very same models to show that fiscal policy might be effective as a
replacement for monetary policy, the response was very different.
Countercyclical fiscal policy was something that New Classical economists had
thought they had killed off for good.

[2] Some technical remarks.

(a) Indivisibility of labour, reflecting the observation (e.g.
Shimer, 2010) that hours per worker are
quite acyclical, has been used in RBC models: early examples include Hansen
(1985) and Hansen and Wright (1992). Michaillat also assumes constant labour
force participation, so the labour supply curve is vertical, and critically
some real wage rigidity and diminishing returns.

(b) Consider a deterioration in technology. With flexible
wages, we would get no rationing, because real wages would fall until all
labour was employed. What if real wages were fixed? If we have constant returns
to labour, then if anyone is employed, everyone would be employed, because
hiring more workers is always profitable (mpl>w always). What Michaillat
does is to allow diminishing returns (and a degree of wage flexibility): some
workers will be employed, but after a point hiring becomes unprofitable, so
rationing can occur.

(c) Michaillat adds matching frictions to the model, so as
productivity improves, rationing unemployment declines but frictional unemployment
increases (as matches become more difficult). Michaillat’s model is not New
Keynesian, as there is no price rigidity, but there is no reason why price
rigidity could not be added. Blanchard and Gali (2010) is a
NK model with matching frictions, but constant returns rules out rationing.

[3] I do not think they will rise enough, because in the
standard formulation the unemployed are still ‘enjoying’ their additional
leisure. One day macroeconomists will feel able to note that in reality most view the cost of being unemployed as far greater than its pecuniary
cost less any benefit they get from their additional leisure time. This may be a
result of a rational anticipation of future personal costs (e.g. here
or here),
or a more ‘behavioural’ status issue, but the evidence that it is there is undeniable. And please do not tell me that
microfounding this unhappiness is hard - why should macro be the only place
where behavioural economics is not allowed to enter!? (There is a literature on using
wellbeing data to make valuations.) Once we have got this bit of reality (back?) into
macro, it should be much more difficult for policymakers to give up on the unemployed.

Wednesday, 21 August 2013

I’m sure many political scientists hate the way descriptions in
politics so often amount to a position on a straight line. It is
one-dimensional. There is the obvious aggregation problem: should a person or
political party, who is left of centre on issue X, and right of centre on issue
Y, be described at generally in the middle of the political spectrum? How do we
weight the importance of issues X and Y? But there is also a problem about
whether positions are relative or absolute. This matters in part because the
perception among many is that being near the middle is good (‘moderate’), and
being away from the centre is bad (‘extreme’).

Three recent posts made me think about this. The first, by Noah Smith, is part of a current
economics blog topic on Milton Friedman. I happen to pretty much agree with
everything Noah says, but have absolutely no expertise on this - on matters of
who thought what decades ago, I am curious but not interested enough to do any
work. (Much better to leave it to David Glasner or Brad DeLong.)However it did strike me as
obviously relevant to what has happened to the political centre, at least in
the US.

One of Paul Krugman’s frequent complaints is that political
commentators define the political centre as being somewhere between the
Democrats and Republicans, regardless of the positions that each side take. He
argues that the Republicans today are much more right wing than a generation
ago, so that under this definition the centre today becomes what was right wing
back then. This matters in part because the presumption is that the centre is
the place for commentators to be.

Now one reaction might be: well he would say that, wouldn’t he.
He is just trying to make his own views, which are ‘obviously’ to the left,
sound more centrist than they actually are. But on economics at least, how
politicians see Milton Friedman’s views provides some sort of objective
yardstick. As Noah points out, some of Friedman’s positions would now be
regarded as dangerously left wing by a good part of today’s Republican Party,
whereas they were not so regarded 30 years ago.

The second post was my own, and the comments on it. It
was about the increase in support for parties away from the centre in the UK
and Netherlands, which I thought could be related to the recessions and
austerity there, and more particularly to falling real wages. (Incidentally
Robert Reich wrote a post on the same day making a similar argument
about US politics.) I received many interesting comments on my post, and I want
to thank everyone involved. A persistent theme was that I was wrong to call
UKIP and the Freedom Party ‘far-right’, and imply any kind of equivalence to
fascism.

I deliberately did not use the term
fascist. Nor did I intend to imply that UKIP or the Freedom Party was fascist,
or indeed that they were comparable - except to the extent that they are to the
right of their respective and longer established mainstream right-of-centre
parties. I used the term ‘far-right’ to denote this, as commentators often do,
but I appreciate that many people read that as short for ‘furthest-right’
rather than the ‘farther-right’ that I had in mind.

I think many of these comments raised important issues. For
example, would it make more sense to characterise UKIP and perhaps others not
as a point on a left/right spectrum, but instead as specific issue
parties? But the comments also revealed how sensitive people are to where the
party they may support or sympathise with is placed on the political spectrum,
and the obvious reason why. The endpoints of the political spectrum are
typically defined by fascism and communism, and therefore the farther away you
appear to be from those extremes, the better. Whether that is a deficiency or
an advantage of this simple left/right model is an interesting question.

Why this may have a more substantial importance is illustrated
by the third post, which involves think thanks in the UK. The right of centre
think tank, the Centre for Policy Studies (CPS), had publicised its study into BBC bias, based in part on how the
BBC uses different think tanks. [1] Part of their argument is that the BBC
often calls left-of-centre think tanks ‘independent’, but mentions the
ideological position of right wing think tanks. One of the think tanks it
defines as left-of-centre is the Social Market Foundation (SMF). Yet,
as this post from SMF complains, the SMF do not think
of themselves as left-of-centre, and they provide evidence about why that
description is wrong.

Now I have worried in the past about whether some think tanks are in the business producing
propaganda instead of being in the business of thinking. So I cannot resist
quoting the end of SMF’s post. “Especially on a significant issue of public
debate - ie. public service broadcasting - think tanks owe a duty to follow the
evidence. Or are CPS doing something slightly different than the normal work of
a think tank? Without more evidence, I won't stick any other name on them for
now.” The post is both short and amusing (unless you work for the CPS), so please
have a look. [2]

Yet putting the thinking versus propaganda issue aside, this
little tiff does illustrate why these issues can have immediate relevance. An
organisation like the BBC tries very hard to be balanced. How you achieve
balance depends in many cases on a judgement about where positions or
organisations are on the left/right spectrum. The spectrum becomes like a
balance scale, with the pivot right in the middle. So if you can persuade an
organisation like the BBC that the mid-point is not where they thought it was,
you can significantly change the content of their reporting and coverage. Or,
even more seriously, if you can convince others that the BBC’s judgement is
wrong, you can threaten their future.

If you think I’m being alarmist in this respect, here is how
the director of the CPS ends his comment on their own research. “The most
important [question] is why should everyone in the UK be forced to pay a poll
tax to support an institution which has so conspicuously failed for so long to
obey its founding principle of impartiality?” A serious charge if true, but is
it true? It is clear
that governments (of whatever colour) put a lot of pressure on the BBC,
although measuring its effect is very difficult (although sometimes the
circumstantial evidence is strong).

However some simple things can be measured, like how much coverage
different political parties get. Of course coverage always tends to be biased
towards the party in power. But, as Justin Lewis of Cardiff University’s School
of Journalism notes,
one study
suggests that whereas in 2007 the margin between the Labour government and
Conservative opposition was less than 2 to 1, the margin in 2012 favoured
Cameron over Miliband by more than 3 to 1, with a ratio of more than 4 to 1
between Government and Shadow Ministers. So on this count, the people who
should be claiming that the BBC is biased is Labour, not the Conservatives or
the right. Are we in danger of entering that state of affairs where everyone
just ‘knows’ that the BBC is biased to the left, just as everyone ‘knows’ that
there is a liberal bias in the US media, without bothering with that annoying
stuff called evidence?

Now one response to this emerging state of affairs is to ask why
the left does not bang on about media bias the same way as the right does. Although with a coverage ratio of 1 to 4, perhaps they do, but we just do not get to
hear about it.

[1] The publicity appeared to predate publication of the
report, which seemed like a strange thing to do.

[2] The blog response from the CPS is also worth reading. As
far as I can see, their reason for characterising the SMF as left of centre is
that their objective is to “champion
policy ideas which marry markets with social justice and take a pro-market rather
than free-market approach.” So social justice in the context of a pro-market
approach is left wing! One rather telling comment on the SMF post suggested
that the CPS used transparency of funding sources as their guide to who was left or right
wing.

Tuesday, 20 August 2013

How do we count the cost of fiscal austerity? The most obvious
question to ask, at least for a macroeconomist, is how much higher GDP would be
without it. This is what Oscar Jorda andAlan Taylor did in
some recent research, which I discussed in this post. All I did in my post was translate this
percentage into the amount of output lost per household, because I think that
kind of number is easier for non-economists to relate to.

Many macroeconomists today might point out that this is an
overestimate of the true cost of austerity, because to the extent that we are
collectively producing less because we are working less, we should offset this
GDP number with the benefit of the extra leisure we are enjoying.

Many other people, including I hope some macroeconomists, might
think that was just silly, and gets things the
wrong way round. To the extent that this fall in GDP is associated with a rise
in unemployment, that increase in unemployment does much more harm than the
amount of goods that unemployed person might otherwise have produced. Chris
Dillow has a useful post on this, and the evidence is in my view
overwhelming. Exactly why macroeconomists continue to get this backwards will
have to be the subject of another post.

David Stuckler, who is in the sociology department
at Oxford but who I do not think I have ever met, looks more generally at the
impact of austerity on health. Together with Sanjay Basu from Stanford, they
have written a book called ‘The Body Economic: Why Austerity
Kills’. There is a NYT OpEd by them here, a Mark Thoma synopsis here, and for those who like podcasts an
interview (with transcript) here. What Stuckler and Basu do is essentially
cross examine a large amount of health data across countries and across time,
looking at the relationship between recessions and particular austerity
measures with health, including deaths. The examples are varied and interesting:
for example how improvements in child mortality and reductions in tuberculosis
and whooping cough in the 1930s were correlated with the extent to which state
governors embraced Roosevelt’s New Deal (will we see the same with Obamacare?),
to how HIV has increased and malaria returned to Greece as a result of health
cutbacks.

Of course what we are talking about here are particular forms
of fiscal tightening: cuts to welfare and health programmes in particular, but
more generally measures that hit the vulnerable poor rather than the rich. A
programme to reduce government deficits that only involved increasing taxes on
the reasonably well off would have a far less serious impact on health. Their
book is also about how best to use public money to most effectively improve
health outcomes, and how cutting this money in the short term not only has a
negative impact on health, but can also raise costs in the longer run.

For this reason, it would be pointless to say that X amount of
fiscal contraction leads on average to some Y deterioration in health outcomes.
Nevertheless, the frustration the authors clearly feel is self evident. Talking
of the UK government’s new regime for disability testing, they say “It was hard
for us, as public health researchers, to understand the government’s position.
The Department for Work and Pensions, after all, considered cheating a
relatively minor issue.” Talking more generally of austerity, David Stuckler says: “These are massive uncontrolled
experiments with entire populations. Had austerity been organised like a drug
trial, with a board of ethics, it would have been discontinued, given evidence
of its deadly side-effects and the failure of its purported economic benefits
to accrue.”

Now some might say that because austerity need not necessarily
involve measures that have large negative health outcomes, statements like
this, and indeed the title of their book, is alarmist. This is similar to the
Troika saying that they are quite right to insist on fiscal contraction so that
the interest on Greek loans can be repaid, because it is up to the Greek
government how it chooses to reduce its deficit. Typically, however, the same
people who make that kind of excuse are also those who want to direct austerity
to cutting spending rather than raising taxes, and who complain about the
‘burden’ of social programmes.

Let me end by quoting the conclusion of their New York Times
article. “One need not be an economic ideologue — we certainly aren’t — to
recognize that the price of austerity can be calculated in human lives. We are
not exonerating poor policy decisions of the past or calling for universal debt
forgiveness. It’s up to policy makers in America and Europe to figure out the
right mix of fiscal and monetary policy. What we have found is that austerity —
severe, immediate, indiscriminate cuts to social and health spending — is not
only self-defeating, but fatal.”

Thursday, 15 August 2013

First, I want to admit to a failure of imagination. Although I described this post as perhaps one of my better forecasts, I
did get one important detail wrong. I said (in May 2012) that if there was a
risk that UK growth would not come good by 2015, the Chancellor would apply
additional stimulus measures, and I suggested investment incentives for firms as
an example. That was a dumb example. I suggested it because I thought it made
macroeconomic sense. Yet it was dumb because I also knew by then that this was
not the way George Osborne thinks. I should instead have asked myself what
stimulus measure would provide the best political advantage. And the obvious
answer is to make it easier for people to buy houses, because this pushes up
house prices. Now, as an economist, you might think rising house prices is the
last thing we need, with UK house price to earnings ratios still very high (see
below). But from a political point of view, if you are trying to get
homeowners’ votes, it makes a lot of sense to engineer a short term increase in
house prices, particularly if you make it immediately easier for those who want
to buy to get ‘onto the ladder’.

So that is what the Chancellor did, with his ‘Help to Buy’ scheme, which either provides guarantees for a
significant proportion of 95% mortgages, or provided top-up loans for up to 20%
of the house price. Frances Coppola is shocked. She writes

“As my regular readers know, I am determinedly politically
non-aligned, so what I am going to say now will probably shock a lot of people.
Osborne's behaviour both angers and frightens me. He is playing brinkmanship
with the UK economy to achieve political ends. Nothing he does makes much sense
from an economic point of view - which is why the flagship Help to Buy scheme
has been universally panned, even by his own department and by people from his
own party. But if you view his actions as entirely determined by his desire to
secure a Conservative victory in 2015, it all makes perfect sense. He is
dangerous.”

As my regular readers will know, I’m afraid I very much agree.
In my ‘final verdict’ on the Chancellor, I wrote “He is a political tactician, who time
and again has put party political gain ahead of the economic interests of the
economy.” (That should have been ‘of the country’, but you know what I meant.)

However, as I always like to try to think well of this
government’s macroeconomic policy, let me put the argument that getting a
recovery by making it easier to borrow money to buy houses makes some sense. It
goes something like this. An important reason why the recovery so far has been anaemic
is that UK banks are broken. So they are being far too cautious in lending for
house purchase. In particular, they are worried that house prices could well
fall, and they do not want to pick up the tab if this happens. If you think
that is a distortion (because you think they are being too risk averse), then
Help to Buy just corrects that distortion. In addition, there are good reasons why one of the byproducts of this
scheme might be a boost to aggregate demand.

What is wrong with this argument? While the idea that UK banks
are being excessively risk averse in their lending to small businesses is quite
plausible, the argument applied to housing is
not. The chart below is Nationwide’s first time buyer house price to mean gross
earnings ratio.

It has fallen as a result of the recession, but remains
historically very high. There are two obvious reasons why it is so high: an
inability over the last decade or two to increase housing supply in line with
demand, and the fact that interest rates are currently very low. It is a clear
objective of government policy to remove barriers to increasing supply, and at
some point in the not too distant future interest rates are likely to rise. There
is therefore a significant chance that in the medium term real house prices
will fall. So it is quite reasonable that banks want to transfer that risk on
to someone else.

Now you could say why shouldn’t that someone else be the government?
What does it matter if at some point in the future taxes are raised or spending
cut to pay for the losses the government will incur on these schemes. If it
gets us a recovery, that is a cost worth paying. And that is half right. After
all, fiscal stimulus involves spending now, but paying for that with higher
taxes or lower spending later. Yet this comparison shows how wrong this scheme
is. If we borrow now to increase public investment, then when taxes are higher
in the future to pay back that borrowing we have something to show for it. If
taxes go up in the future to cover the defaults on loans made to house buyers,
we have nothing.

So I think Frances is exactly right. The Chancellor is a very
skilled political operator, and with schemes like this the UK is in danger of enjoying
another five years of bad economic decisions designed to gain party political
advantage.

Wednesday, 14 August 2013

This issue has surfaced again (see Krugman and Rowe). I wrote a post awhile back on this, but it was quite difficult (for me at least!), so here is an attempt to restate the key conclusions more directly. Ashok Rao has a post covering some of the same themes as my earlier post. The key point here is that I am going to follow Nick in saying that money is different from bonds because money is irredeemable, but even then the Pigou effect is not a magic bullet that gets us out of a liquidity trap.

How is the Pigou effect supposed to get you out of a liquidity trap? In a liquidity trap nominal interest rates are at zero (ZLB). However pretty well everyone agrees that if by some means the monetary authority could induce higher inflation expectations, then the ZLB could be overcome, because real interest rates would fall, stimulating demand. That is a real interest rate effect. It is what some people think Friedman had in mind when he was so critical of Fed policy in the Great Depression. (I have no idea if this is true.) It is what Michael Woodford argues the Fed should now promise to mitigate the impact of the ZLB. It is what Paul Krugman recommended Japan do to get out of the lost decade. But none of these things is the Pigou effect.

The Pigou effect is when the authorities keep the current stock of money constant, and falling prices mean that its real value increases. The idea is that at some point people feel sufficiently wealthier that they spend more, which adds to demand. For this to work, we have to assume that the nominal stock of money will remain unchanged, unaffected by falling prices. Now you might say fine, let’s assume that. But if you do, you might also agree that the fall in prices is temporary. Simple neutrality implies that if you hold the money stock constant, falling prices today will mean higher prices tomorrow. But we have already established that in that case you do not need a Pigou effect, because higher inflation tomorrow at the ZLB will mean lower real interest rates, and you get the demand stimulus the good old real interest rate route. Furthermore, if people understand that prices will rise, they are not really wealthier in an intertemporal sense, because their extra real money balances will be inflated away. If you like, they save their extra real money balances today to pay for future inflation taxes. [1]

The alternative case is where future inflation does not increase as current prices fall - as would happen if the monetary authority targeted future inflation for example, and did not raise that target as prices fell. That would imply that the current nominal money stock was not fixed, because to prevent future inflation rising, the monetary authority must at some stage reduce the nominal stock of money - long run neutrality again. How does it do that without raising interest rates? It could raise taxes. But if it did that, then Ricardian consumers would not think of their higher real balances today as wealth, because this would be offset by future tax increases.

The central bank could reduce the money stock by selling some of its government debt. But under the conditions that Ricardian Equivalence holds, that has the same effect. Now the government will have to raise taxes to pay the interest on that debt, whereas before any interest they did pay came straight back via the central bank.

We can sum this up rather neatly, as Willem Buiter did here with the aid of lots of maths, by saying that what matters is the terminal stock of money, not its current value. The government can only make people feel wealthier by printing money if people believe that the increase in its real value is permanent.

We can apply the same reasoning to a helicopter drop. The first issue is whether issuing money to pay for a tax cut is any different from issuing bonds, and in particular does Ricardian Equivalence apply? Now macroeconomists are confused on this (see my earlier post), but here I’m happy to follow Nick and agree that money financing is different, because money is not redeemable. So a permanent helicopter drop of money will tend to increase consumption. To put it another way, the Ricardian Equivalence mechanism does not apply to a helicopter drop.

However there is another, more economy wide mechanism. If long run neutrality holds, and if people understand this, they will realise that their extra wealth will eventually be inflated away, so they are no better off. (Equivalently, their tax gain today will be offset by a higher inflation tax at some point.) But those expectations of higher inflation, if we are stuck in a liquidity trap, will shift consumption to the present, so the helicopter drop increases demand through a real interest rate mechanism.

The bottom line is that we can forget about the Pigou effect as a way out of the liquidity trap, at least in what is now our baseline macro model. What is important for the liquidity trap is expectations about future monetary policy. If monetary policy allows future inflation to rise, and expectations are rational, we can get out of the trap. If they do not, then we stay in the trap until some other force gets us out. That force will not be the Pigou effect.

[1] What if neutrality does not hold? Neutrality is pretty basic,
but for the sake of argument let’s briefly consider this. Consumers are now
wealthier, because they have more real money with no future costs to come.
However I have the following problem if we stick with intertemporal consumers
of the Ricardian type, who only consume
the annuity value of any increase in their wealth. When do these agents
consume their new found wealth? Any answer except never appears to violate
consumption smoothing.

Monday, 12 August 2013

Everyone knows about the return of extremist politics as a
result of austerity in Greece. (Paul Mason’s reporting has been
particularly strong over the last few years.) The link between economic
depression and far right extremism in the 1930s is also well documented.
Yet I suspect there is a tendency to assume that this kind of thing only
happens in ‘immature’ democracies. This
assumption is wrong, as both the Netherlands and the UK currently show.

The Netherlands has been run by a parliament since at
least 1848. Coalitions are the norm rather than the exception, and there is
a general desire to achieve consensus
on important political issues. Before the formation of the Euro, the extreme
right in the Netherlands could be described (pdf)
as marginal, which was not the case in France for example. Yet recent opinion
polls suggest
that if elections were held now, the far right Freedom Party
would become the largest party in parliament. The left wing Socialists have
also been taking support away from the centre-left Labour Party. What the two
extreme parties have in common compared to the mainstream is opposition to further
fiscal austerity.

So far, there has been a depressing consensus
among the more centrist political parties in the Netherlands that they need to
follow the Eurozone’s fiscal rules. The
economy is in recession: GDP fell by 1% in 2012, and will probably fall by a
similar amount this year. Unemployment
is rising: the Chart below shows OECD forecasts and also OECD estimates of the
output gap. Of course this has increased the budget deficit, and so we have had
a series of austerity measures in an attempt to keep the deficit at 3% of GDP
to stay within the Eurozone’s fiscal rules. [1] When the Freedom Party, which was
part of a right wing coalition, refused to support these cuts in 2012, they were passed
by a coalition of the centre, egged on by the European Commission.

OECD Economic Outlook Estimates for the Netherlands

Of course the Netherlands, unlike Greece or Ireland or
Portugal, has no problem funding its budget deficits, so here austerity is very
much a political choice. Recent polls suggest the public has had enough, and that as a result support for the Euro itself is suffering. The
union movement has been active in its opposition, but more recently
prominent business organisations have also begun to question austerity,
although predictably their opposition has focused on tax increases rather than
cuts to welfare.Coen Teulings, who
departed as head of the highly respected CPB in April, was vocal
in his opposition to recent cuts, but the central bank has been much more supportive
of austerity.

The UK has also seen the emergence
of a politically successful far-right party: UKIP. This is also unusual from a
historical perspective: since Oswald Mosley the UK has a proud tradition
of resisting parties of the far right. UKIP’s popularity is not normally linked
directly to austerity, but instead to widespread hostility to both immigration
and the European Union. As a result, the Conservative Party has taken
economically damaging positions on both issues in an attempt to reduce UKIP’s
appeal. Chris Bertram at Crooked Timber recounts
in detail the sorry state of the UK ‘debate’ on immigration. Yet the link
between concerns about immigration on
the one hand and unemployment and low wages on the other is fairly obvious.
Despite all the valiant attempts by Jonathan
Portes and others
to focus on the evidence, this is one of those cases
where the combination of tabloid media hype, partisan political advantage and
‘common sense’ normally wins, and as a result the UK Labour Party seems to
spend much of its time trying to ape the Conservatives.

Why has support for the far-right grown in the UK and the
Netherlands, while in France for example the far-right did not make a breakthrough
in 2012?
No doubt a complete answer would be quite complex. However it is worth noting
that the UK and the Netherlands have both experienced sharp falls in real wages
in the recent past. The OECD expects real compensation per employee to have
declined by a total of about 4.5% in the three years 2011-13 in the Netherlands,
and by about 5% in the UK. The decline in the Euro area as a whole has been much
smaller, at less than 2%. In France real wages have increased a little in all
three years. Figures recently calculated
by the House of Commons library show a similar picture, with only Greece and
Portugal doing as badly as the UK and Netherlands since mid-2010. [2]

In both the UK and the Netherlands we have recession and fiscal austerity, where the recession has been associated with marked falls in
real wages as well as increases in unemployment. In both cases I would argue
that there has been no effective opposition to fiscal austerity from the
political centre, which helps encourage support for the political extremes. But
that is probably as far as the similarity goes, because the position of the
centre-left Labour Party in the two countries is very different.

In the UK the Labour Party is in opposition. It seems their
general tactic on issues like austerity or immigration is not to question
the underlying assumptions on which government policy is based. Perhaps the
idea is to avoid being branded as irresponsible (austerity) or out of touch
(immigration), while hoping to retain the support of those who do strongly
oppose government policy. This position has so far been tenable partly because
there is no strong party to the left of Labour. We may have to wait until 2015
to see if this strategy is successful.

The position of the Labour Party in the Netherlands is more
immediately problematic. It is now part of the coalition enacting cuts. The Socialist Party, which is to the left of
Labour and which does not support austerity, has moved ahead of Labour in the
polls. In April there was a ‘social accord’, where the unions and business
groups signed up to the budget deal proposed by the government. Further
cuts are now required beyond those agreed in April to meet the fiscal rules,
and the unions (and perhaps business leaders) are now actively campaigning
against austerity. Yet it will be hard
for the centre-right to ask Brussels for a reprieve, as their leader and Prime
Minister, Mark Rutte, has followed
Germany in taking a hard line on the 3% deficit limit and the Commission’s
enforcement of it. The reasons for
Labour to back additional austerity are much less clear.

So in the Netherlands and elsewhere in Europe, on the issue
of the stupidity of pro-cyclical fiscal policy, it is only the views of politicians
on the far-left or far-right that matches those of the majority
of macroeconomists. Given the social,
economic and political consequences of declining real wages and rising
unemployment, which fiscal austerity only makes worse, this is both a very sad and rather dangerous state of affairs.

[1] Yes, this is the actual balance. The OECD estimate that the underlying primary deficit was 1.4% of GDP in 2012, will be 0.1% in 2013, and in surplus in 2014. I think those economists who suggested that the new Eurozone Fiscal Compact would be more enlightened than the old rules need to ask themselves why that has not happened.

[2] Of course Germany has also avoided falls in real wages.
In Germany there is a clear consensus among the parties of the centre for
imposing austerity on others! While Merkel’s position is well known, Andrew
Watt discusses here
how the macroeconomic position of the centre-left SPD goes from bad to worse.